Wednesday, October 8, 2014

Alex Salter and Thomas Hogan have a working paper that points to problems with a central-bank directed policy of targeting the level of nominal GDP. The argument is that while such a policy may helpfully stabilize aggregate demand, it will create undesirable consequences for aggregate supply.

I certainly appreciate the work that Salter is doing on Nominal GDP level targeting I don't find their argument persuasive Or at least, I think there is a problem with the example they use to argue that divergent expectations between the central bank and market participants will cause problems.

They consider a situation where some shock has pushed nominal GDP below target. A central bank targeting nominal GDP will seek to return nominal GDP to its previous growth path. They assume that the central bank considers the shock "nominal" and so increases the quantity of money to offset the decrease in velocity Market participants, however, believe that the shock was structural. Real wealth has been destroyed. And so the market participants do not believe that the central banks commitment to returning nominal GDP to target is credible.

However, a belief that a shock is "real" and has destroyed wealth doesn't prevent the central bank from returning nominal GDP to target. It simply means that that the price level will shift to a higher growth path. The inflation rate would pick up for a time, and then return to its previous rate, but now on a higher growth path. This "structural" problem would also be reflected in a lower growth path for real output.

The central bank, believing that the shock was solely nominal, would expect instead that real output would recover to its previous growth path, and the price level would also return to its previous growth path.

The divergence in expectations in this situation would be that the market participants, believing the problem to be structural, will expect the recovery of nominal GDP to be a shift to a higher growth path of prices while real output remains on a lower growth path. The central bank, on the other hand, expects that real output and the price to will return to their initial growth paths once the monetary disequilibrium is relieved.

What is most puzzling about this example is that if the central bank agreed with the market participants and thought the problem was structural, it would still expand the quantity of money enough to offset any change in velocity and return nominal GDP to the target growth path. Then the central bank, like the market participants, would expect this to involve a shift to a higher growth path for the price level and a lower growth path for real output.

That there is some structural problem that persistently reduces productive capacity does not make returning nominal GDP to target unfeasible. Further, it is difficult to see how this leads to an excess supply of money.

Salter and Hogan describe how the supposed structural problems have result in a leftward shift in the long run and short run aggregate supply curve. Then they oddly describe this in micro terms as a inward shift in the production possibilities for various goods and services. (I would think production possibilities is a macro concept.) The relevant micro concept is that the supply curves for various goods and services are believed to have shifted to the left. Firms believing that would tend to raise their prices along with reducing their production. While this response is undesirable if they are making a mistake, it is consistent with a return of nominal GDP target. As explained above, this micro response is consistent with the price level shifting to a higher growth path and real output shifting to a lower growth path.

Salter and Hogan are concerned by the excess supply of money generated by the central bank as it pushes the price level higher and point to the stagflation of the seventies and a variety of empirical studies that suggest that increased inflation is disruptive. In my view, the seventies are not very instructive, since that was a period where nominal GDP was not on a stable growth path but rather had an accelerating growth rate.

Of course, a study of a nominal GDP level path would most certainly show that higher inflation was associated with lower real growth in the short run. That is how it works. When supply side factors lead to slower growth in productivity, inflation will be higher. As for any long run relationship between inflation and real output growth, this involves setting the growth rate implied by the rule. Is a 5 percent growth path for nominal GDP better? That would imply 2 percent inflation if potential output is on a 3% trend. Or would 4 percent, 3 percent, or 2 percent be better.

There is no doubt that a nominal GDP level target will do worse than an inflation target in stabilizing short term inflation expectations. However, I believe that expectations that nominal GDP will be at a particular level in future periods provides a better macroeconomic anchor than knowing that the price level next period will be at the same level.

I do think that divergent expectations between firms setting prices and making production and employment decisions and the central bank could lead to problems. I believe that nominal GDP targeting avoids problems due to difference in views about whether shocks are nominal or structural--at least to the degree that this simply involves differences expectations regarding the growth path of the price level or real output. Instead, I would be more worried that entrepreneurs are naive Keynesians and believe something like the paradox of thrift.

So, suppose there is some structural change so that real wealth has been reduced. Being poorer, people spend less. That implies that nominal GDP will remain below target. While the central bank create more money and lower interest rates, if no one wants to borrow, then they are just pushing on a string.

Now, in reality, a decrease in wealth does reduce consumption and increase saving. Those who are poorer seek to rebuild their lost wealth. However, the increase in saving supply results in a lower natural interest rate. Assuming market rates adjust, investment expands enough so that total spending is not depressed Thinking of a misallocation of resources--capital specific to housing construction lost, for example, then this added investment can be used to rebuild the other types of capital goods that had been crowded out by the excessive investment in sawmills or cement plants.

What would be ideal is for the reallocation of resources to occur with prices and output based upon on target nominal GDP. That productive capacity might be permanently reduced doesn't make this impossible at all. For example, capacity constraints for capital goods more in demand may result in higher spending on them generating only modest increases in production and substantially higher prices. Meanwhile, the reduction in prices for houses and housing construction equipment and perhaps other consumer goods might be much smaller along with larger decreases in output. The price level rises and real output falls. Hopefully, this upward shift in the growth path for the price level and reduction in real output will be partially relieved and reversed as resources shift and bottlenecks ease.

But suppose entrepreneurs are naive Keynesians. They don't believe that nominal GDP will return to target. They base their investment decisions on the assumption that spending on output will remain on its current growth path. With those expectations, they invest less. Must the central bank create an excess supply of money to force nominal GDP back to target?

Perhaps. Of course, these perverse expectations imply a lower demand for investment and so a lower natural interest rate. A lower market interest rate implies a higher demand for money. Is the quantity of money necessary to return nominal income to target simply accommodating this unusually high demand for money?

Perhaps this is what Salter and Hogan have in mind. My thought is that such entrepreneurial error is possible. It seems to me that what is an excess supply of money and a market rate below the natural interest rate is ambiguous in this situation. However, I would also see this as less a persistent problem and more an issue of learning the new regime. And so, any such problems would become less severe as time passed.

Sunday, October 5, 2014

Scott Sumner argued against the notion that because the federal government can print money, it doesn't need to worry about the cost of providing services. He argued that while the issue of currency allows the government to collect a small revenue--perhaps 1% of GDP--through seignorge, government spending is much greater than that, so on the margin, changes in government spending require taxes.

In response to a comment, Sumner then amended his argument to recognize that seignorage revenue is not free. However, he argued that if we compare a scenario with no currency to one with currency, those bearing the cost of holding currency receive benefits greater than that cost.

As an analogy, he describes the introduction of a government lottery. Those participating in the lottery get to enjoy legal gambling, and the government collects the revenue. He notes that since private competitive lotteries are clearly possible, a more appropriate baseline shows that funds from a government monopoly lottery are not "free" but rather they come at the expense of those purchasing lottery tickets.

Sumner then considers privatized hand-to-hand currency and repeats his longstanding proposal to have the government contract out the provision of hand-to-hand currency. He holds that competitive issue would be wasteful, pointing to the practice of banks of giving away toasters to those making deposits as a work-around interest rate ceilings.

First, the seignorage income of the government from the monopoly issue of currency is imposed on those using currency. With a zero inflation rate and growing currency demand, those wishing to increase real currency balances must increase their nominal currency balances. They do that by having nominal expenditures less than nominal receipts. Real consumption plus real saving in forms other than the accumulation of money balances must be less than real income.

With inflation, say at the 2% rate Sumner favors, it is necessary to accumulate nominal balances to maintain real balances. Again, nominal expenditures must exceed nominal receipts. And so, real consumption plus real saving must be less than real income. The inflation tax on real money balances is paid by those seeking to maintain their real money balances.

Evidently, people benefit from holding currency more than this cost. But the tax on currency balances results in an excess burden like any other tax. The conventional wisdom is that the proper baseline for comparison is a deflation rate equal to the real rate of interest so that there is no opportunity cost to holding currency. Little seignorage revenue is possible with a deflation rate equal to the real interest rate. If the real interest rate is equal to the growth rate of real output and the demand for currency is proportional to real income, then there is exactly no seignorage revenue--a constant nominal quantity of money is optimal.

Just about all of this analysis is worthless when considering free banking. Banknotes are debt instruments. While the nominal interest rate may be zero, a bank that issues them is still borrowing and must stand ready to pay them all back. There is nothing like seignorage revenue for any bank.

Of course, borrowing at a zero-nominal interest rate is lucrative under normal circumstances. Banks can fund a portion of their asset portfolios with no interest cost. The immediate effect then is to enhance the profitability of banks.

However, if banks make more than normal profits, then there will be entry into the industry. Considering banks as financial intermediaries, the resulting increase supply of banking services will reduce the equilibrium margin between the interest rates banks charge and pay. Entry continues until profitability returns to normal. The impact then will be an increase in the interest rates banks pay on deposits and a decrease in the interest rates banks charge on loans.

And so, if the government monopolizes the issue of currency so that it can collect seignorage, then this comes at the expense the customers of banks--you and I. We earn lower interest on bank deposits and pay higher interest on bank loans.

Hand-to-hand paper currency was initially issued by private, competing banks. The government step-by-step monopolized the issue through legal restrictions. Since this paper currency was initially redeemable in terms of gold, it was either a liability of a private central bank or a type of government debt By creating a monopoly, the tendency of competition to dissipate the rents made possible from borrowing at a zero nominal interest rate could be shared by the private owners of the central bank and the government As time passed, those benefits have gone more and more to governments. With the end of the gold standard, it became possible to think of this monopoly government currency as if it is paper gold--a pure outside money with the amount issued creating a revenue.

But the private alternative remains a competitive banking system. My own view is that it is entirely possible to pay interest on hand-to-hand currency. When depositors withdraw currency, they can continue to earn interest until the currency is returned to their bank. One hundred years ago, the record keeping would have been very burdensome, but it is very feasible today.

Further, to the degree it is desirable to tie price level performance to optimal holdings of hand-to-hand currency, how much more likely would this occur when it doesn't involve government giving up a source of "free" revenue and instead involves shifts in how the benefits are distributed among the customers of banks?

Friday, October 3, 2014

October 4, 2014 will be Leland B. Yeager's 90th birthday. He has made many contributions to economics and political economy.

Like the other charter members of the Virginia School of Political Economy, he is a mainstream libertarian. However, he has been a consistent supporter of a rule-utilitarian approach to moral and political philosophy. He has always worked to weave together the best insights from the neoclassical and Austrian traditions. But perhaps more importantly, his contributions to Chicago-school monetarism provided tremendous insight into the essential role of money in the economy--what he described as monetary disequilibrium. Finally, when monetary innovation made the definition of quantity of money problematic and measured velocity lost its remarkable stability, Yeager did not follow the rather convenient shift in Chicago-school monetarism, towards rational expectations and market clearing. Rather he turned towards free banking and privatized money.

Yeager took the view that the most important and interesting macroeconomic problems involve the process by which a market economy adjusts to imbalances between the quantity of money and the demand to hold money. In particular, inflation is the equilibrium result of a quantity of money greater than demand and recession is part of the adjustment process of a quantity of money less than the demand. While for many years Yeager favored a money supply rule, suggesting he judged that shifts in the demand for money were unlikely to be a serious problem, he always considered possible a recession due to an increase in the demand to hold money.

In an early paper, "A Cash Balances Approach to Depression" (1956,) he discussed a possible scenario where an increase in the demand for short and safe government bonds might spillover to an increased demand for money, leading to a recession. That a recession might occur despite an increase in the quantity of money and in combination with exceptionally low interest rates would be no surprise to those who grasp Yeager's view of monetary disequilibrium.

Yeager always argued that economists understood the importance of aggregate demand and sticky prices and wages long before Keynes. The review of earlier textbook economics in "The Keynesian Diversion" (1973) is instructive, but I greatly appreciated his discussion there of what I like to describe as the "Yeager Effect." Because the demand to hold money is positively related to real income, any reduction in real income results in a reduced demand to hold cash balances. Starting from a condition of monetary equilibrium, as long as the quantity of money doesn't decrease as well, the result will be excess money balances and so increased spending on output. In one sense, this just shows how adverse productivity shocks are inflationary. However, it is more important when considering supposed "demand shocks" that are not associated with changes in the quantity of money or the demand to hold it.

Consider the paradox of thrift. Does an increase in saving result in reduced real output and income? Unless that increased saving involves either directly or indirectly an increase in the demand to hold money, then any reduction in real output and real income will result in reduced money demand and increased expenditures on output. For another example, suppose that one firm reduces its investment expenditure because it is building capacity to sell to some other firm, and weak animal spirits cause it to fear that the other firm will not undertake the investment expenditures necessary for the planned sales to materialize. Supposedly, the reduced expenditure then leads to reduced output. However, unless these firms are holding money rather than spending on capital goods, the reduced real output and income would lead to a reduced demand to hold money, and increased expenditure on output. Coordination failure accounts of demand constrained production, absent an imbalance between the quantity of money and the demand to hold it, are self-contradictory.

The "Yeager Effect" is dependent on the monetary regime. The assumption is that real output and real income shift, the demand to hold money changes the same, but the quantity of money remains unchanged. Yeager was certainly aware that a banking system might respond to depressed economic conditions by reducing the quantity of money rather than holding it steady. This points to an additional major emphasis of his work--the distinction between money and credit. For Yeager, money is the medium of exchange. The quantity is the amount that exists and the demand is the amount that people would like to hold. Credit, on the other hand, involves borrowing and lending. Banks can lend money into existence, expanding the quantity of money even if there is no one who wants to hold the additional balances. And those wishing to hold additional money balances have no directly reason to show up at a bank seeking to borrow. The interest rate that clears credit markets does not necessarily keep the quantity of money equal to the demand to hold it. It is the price level for goods and services, along with the prices of resources, including nominal wages, that must adjust to keep the real quantity of money equal to the demand to hold it.

As financial innovation made measurement of the quantity of money problematic, Yeager became more interested in free banking and privatized monetary alternatives. Along with Robert Greenfield, he introduced the Black-Fama-Hall Payments System in "A Laissez-Faire Approach to Monetary Stability" in 1983. The emphasis was on a medium of account separate from the medium of exchange. They suggest that the medium of account sould be a broad bundle of goods and services. This would be roughly similar to a gold standard, but with a bundle of goods defining the dollar rather than a specific quantity of gold. With the relative price of this bundle of goods stable, there would be no need for shifts in the price level to clear markets. There could be no significant inflation and no need for a painful recession to generate necessary deflation.

The competing media of exchange were to take the form of checkable mutual fund shares. The prices and yields on each, as well as the quantities, would adjust to keep the quantity supplied and demanded equal for each monetary instrument. Monetary disequilibrium would be avoided without the need for adjustments in prices of goods and services or wages and other nominal incomes. Interestingly, there would be no zero nominal bound on interest rates with such a monetary order. The nominal yields on these mutual-fund like monetary instruments could be less than zero, along with the yields on any other financial instruments. Of course, that would only be true if such negative nominal yields were necessary to equate quantity demanded and quantity supplied for the monetary and other financial instruments.

As Yeager and others explored this alternative regime, it became clear that the market processes that would apply are similar to a conventional monetary order than appeared at first glance. In particular, indirect convertibility received more emphasis. Checks made out in dollar amounts, and especially inter-bank clearings, would need to be settled. Indirect convertibility is the notion that a dollar claim would be settled with some financial asset, or perhaps even gold, that has a current market value equal to the sum of the market prices of the items in the bundle of goods defining the dollar. The process that would reverse any deviation of the price level from the equilibrium implied by the definition of the dollar would involve shortages of money if the price level were too high and surpluses of money if it is too low. And while individual issuers of mutual funds competing for market share would make appropriate changes in prices and yields as well s quantities to reflect the demands for those using the monies, the entire monetary system would be constrained through at least incipient pressure on the price level, particularly the prices of the items defining the dollar.

While mutual-fund type monetary instruments have some potential advantages, the growing emphasis on indirect convertibility made it clear that the BFH system was consistent with more conventional checkable deposit accounts. The yields and quantities of those could adjust just as well as those on mutual fund shares. And while Yeager and Greenfield had mentioned the possibility of some subsidiary role for privately-issued hand-to-hand currency from the start, the growing emphasis on indirect convertibility suggested that the quantities of banknotes could be limited to the demand to hold them even if the nominal yield on such currency were always zero. Of course, if banks found it unprofitable to issue such currency, then there would be none and all payments would be made by some type of checkable account--deposit or mutual fund.

In working out some of the practical issues in choosing an appropriate bundle of goods to define a dollar, Yeager proposed that monetary instruments be redeemed partially on demand, and then a remainder be settled up subsequent to the measure of the price of the bundle. This pointed to redeemability with futures contracts on a price index, an approach that was pursued by Kevin Dowd and which also pointed to Scott Sumner's parallel work on index futures targeting. Yeager, working again with Greenfield, also explored a "real GDP dollar." which directly points towards a stable value for nominal GDP.

Finally, Yeager not only traced concern with monetary disequilibrium and aggregate demand to pre-Keynesian economics, he also maintained a common sense view that economics is about explaining the real world. He was critical of what he called "hyperclassical" doctrines that in the name of rigor or methodological presuppositions ignore the reality of nominal stickiness and instead seek to explain business cycles as optimal responses to real factors. While better explanations of wage or price stickiness should be welcomed, the absence of such explanation is no excuse to imagine that prices adjust continuously to clear all markets.

I have learned a tremendous amount from Leland Yeager and I hope to learn more. I would encourage other economists to do the same. Happy 90th Birthday!